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Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.

One of the smartest people I know—a brilliant copy editor—used to shake her head as she read articles about bonds and the bond market.

“I think you have to be born with the bond gene to understand bonds,” she would mutter.

What set Mary to muttering, as I recall, was the fact that bond prices tend to move in the opposite direction of interest rates.

“You would think,” she’d say, “that higher interest rates would be good for bond investors. Wouldn’t I earn more?”

Was she in need of a bond-gene transplant? Not really. The impact of rising or falling rates on bond returns varies depending on time horizons.

The short term

When interest rates go up, the market value, or price, of an existing bond immediately falls. This adjustment occurs because an investor wouldn’t pay full price for an existing bond with a face value of $1,000 and a yield of 4% if she could get a similar $1,000 bond yielding 5%. It’s the opposite story when interest rates fall. If prevailing interest rates go from 5% to 4%, you’d expect to pay more for the existing 5% bond than for one yielding 4%.

So in the short run, rising interest rates are bad news and falling rates are good news for an investor who holds bonds or bond funds.

The long term

But over the longer term, rising interest rates can be good for bond investors. And falling rates, although they boost bond prices at first, eventually are not so good for bond investors.

The key is what happens over time as your bond investments throw off income and as bonds mature. The income from your bonds is either spent or reinvested. If you reinvest the income, and rates have gone up, that $100 earns more than if rates fell or held steady. And when a $1,000 bond you own (directly or in a bond fund) matures, you’d rather be able to reinvest that $1,000 in principal at, say, a 6% yield than at 4%. At 6%, money doubles in roughly 12 years. At 4%, it takes about 18 years to double.

For long-term bonds, it’s the interest income—and the reinvestment of that income—that accounts for the largest portion of total returns. Over time, the impact of price fluctuations is outweighed by the impact of reinvestments of income and principal.

The table below illustrates the disparate impact of rate changes over various periods, demonstrating how important an investor’s time horizon is when thinking about the risks of interest rates. For the long-term investor, the bigger risk is lower rates, not higher rates. The reverse is true for the short-term investor.

This element of time is too often missed, I think, in commentary on bonds and in the way some investors think about bonds. For example, bond mutual funds tend to attract increased cash from investors after interest rates have fallen and prices have appreciated—as reflected in cash flows during 2009. After periods of rising interest rates—when bond prices have fallen and bond fund returns are weak or negative—it’s not unusual to see money flowing out of bond funds.

It’s as if investors have a genetic inclination to use the rear-view mirror to guide them in moving forward.

Are there terms or concepts about bonds and bond investing that you find puzzling? Yield curves? Duration? Credit risk and credit spreads?

I’d be interested in hearing about them, then asking some of our bond experts to tackle the questions in a future post or posts.

Like this:

Craig Stock

Craig Stock heads Vanguard's Corporate Marketing and Communications department, responsible for delivering investor information and education in Vanguard’s "plain talk" style.
Before joining Vanguard in 1995, Craig spent two decades in journalism. At The Philadelphia Inquirer, he reported on business and the economy, served as a business editor, and wrote a column on personal finance.
Craig holds a B.S. from the University of Kansas, and was a Sloan Fellow in Economics Journalism at Princeton University's Woodrow Wilson School. He’s also the author of Investing During Retirement, published in 1997.

Comments

Anonymous | November 12, 2009 2:42 pm

Everybody hopes that interest rates will be high when they retire because they want a high income stream. But many people don’t realize that interest rates are largely an assumption of what inflation will do over the term of the bond. Right now interst rates are low because inflation expectations are low. When rates go up it is a reflection of an expectation of higher inflation. So while you will enjoy a higher return when rates go up inflation will be taking just as big a bite out of your purchasing power.

Anonymous | November 8, 2009 9:33 am

I bought a Corporate Bond in May matures 5/2016YTM is 9.82%..Bond value today is 109.635 or a gain over face value od $ 10,116….tempted to sell because of the large short term gain. Good idea or bad idea? Have other bonds also with gains over cost because of lower yields, but what rate does one then need to get to match the hi-yields? or is my question one of short terrm gain over long term, or just greed?

Anonymous | November 7, 2009 4:25 pm

Well one thing about reading all these comments is that I’ve got a lot of company with my deficient financial genes! I always have some of my portfolio stashed in a mutual bond fund because it seems to balance out some of the losses when my other funds go down.

Anonymous | November 7, 2009 1:37 am

Good informative article. Thank you. I figure if I keep reading about bonds even when I don’t understand everything I read, my bond gene will mutate, and I will have an epiphany. You lost me at the chart.

Anonymous | November 5, 2009 10:44 pm

Why not invest in Bonds now… Basically the economy will be slow to recover as people continue to save more and therefore interest rates will be slower to rise. Along those lines, the majority of the economic growth/recovery that has been reported thus far has come about by corporations cutting costs and not “real” growth. Deflation for next 2-3 years is likely making bonds more attractive.

Anonymous | November 3, 2009 7:45 pm

Use bonds as a source of income pure and simple. Buy a broad range index bond fund and forget about it’s NAV. Buy several: a short, an intermediate, and a long term total bond index fund. Buy each for it’s current rate of return and this becomes your decision point. When your return increases beyond this point, reinvest the difference and you will be buying new shares at depressed prices to your original entry price. If rates decline, marvel at your increased net worth. Win win.

Anonymous | October 30, 2009 10:53 am

I believe there is basic flaw in looking at annualized returns for several years. One should reconsider the asset allocation each year, and act accordingly. Under those circumstances, shouldn’t it be the one year anticipated return that guides investment decisions?

Anonymous | October 30, 2009 10:48 am

One issue that needs to be clarified is for individuals that are using bonds for income streams, i.e. laddering bonds and holding them to maturity. In this case there is no loss of the face value assuming the bond is not in default and the only risk becomes a reduction in income if a new bond has a lower interest rate the the one that matures. Of course there is always the effect of inflation reducing the buying power of the income stream but this can be avoided via TIPs.

Anonymous | October 30, 2009 8:49 am

Very good perspective. Two questions/ requests: 1) Can you reproduce the table shown when dividends are not reinvested? and 2) Given the historically low interests rates, do you really expect to see the same numerical relationship between bond pricing (based on duration) and interest rates. For instance if I hold long term bonds with a duration of 10 years and if interests rates rise by 4 pts say over 3 years, will I really see a 40% drop in the price on the bond ??

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At Vanguard, we’ve always believed in candid, direct communication with investors. In fact, it’s one of our core principles. In 2009, we created the Vanguard Blog so that we could talk about what’s happening in our industry and in the economy—and hear what’s on the minds of investors like you. More

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.